How the PCAOB AS #18 Impacts Audit
Conversations on related party relationships and transactions are raging this year within audit firms, audit committees and management groups of public companies, thanks to a relatively new auditing standard.
|Tuesday, February 23, 2016|
By Ron Kral, Corporate Compliance Insights
Conversations on related party relationships and transactions are raging this year within audit firms, audit committees and management groups of public companies, thanks to a relatively new auditing standard. The Public Company Accounting Oversight Board’s (PCAOB or Board) auditing standard number 18 (AS-18) raises the bar for auditors in three critical areas. While this standard has been in effect since 2015, its impact is likely at an all-time high, as external audit firms face another tough round of PCAOB inspections. Whether you are on the audit side or the client side, you are likely to feel the heat from this recent standard. This article addresses the scope, definitions and challenges pertaining to AS-18 for both SEC registrants and their auditors.
Although AS-18 is largely thought of in terms of related party transactions, the scope covers much more, as it establishes auditing responsibilities for:
Collectively, these three areas are referred to as “the critical areas.” According to the PCAOB’s press release on AS-18, the Board took this action “because these transactions and relationships could pose increased risk of material misstatement in company financial statements.” While these critical areas have long been subject to audit scrutiny, this standard raises the bar for auditors with precise guidance and expectations. The press release quotes PCAOB’s Chief Auditor and Director of Professional Standards, saying “the new performance requirements for auditors are designed to provide a cohesive audit approach to three challenging areas that warrant additional auditor effort and focus.”
The PCAOB views the auditor’s efforts for these three critical areas as complementary, since working in one area can easily relate to one or both of the other areas. The essence of AS-18 is to enable the auditor to conclude whether the company has properly identified, accounted for and disclosed relationships and transactions with related parties and executive officers, as well as significant unusual transactions.
AS-18 requires auditors to obtain an understanding of the company’s process, perform inquiries and communicate with the audit engagement team and other auditors. Moreover, the auditor is expected to perform risk assessment procedures required by AS-12 for the critical areas. Additional procedures also kick-in when related party transactions exist, including testing the accuracy and completeness of the relationships and transactions. The auditor must now go further than making some basic inquiries and obtaining management’s representations. Of course, as with all audit standards, the interpretation of the requirements rests on the auditor’s judgment. Simply put, the greater the risk of material misstatement (RMM), the more work effort is expected of the auditor. The increased expectations posed by AS-18, combined with the PCAOB’s tendency to focus on recently issued standards in their inspections, has audit firms laser-focused on related party transactions.
Perhaps the most insightful guidance per AS-18 is Appendix A to Appendix 1 (pages A1-13 through A1-15). This Appendix contains sources of information and examples that may be gathered by the auditor to indicate that related party relationships or transactions exist. It is well worth the effort for both companies and auditors to read and consider these three pages.
Be careful with definitions, as “related parties” as defined in U.S. GAAP is different than “related persons” as defined in Item 404(a) of SEC Regulation S-K. Of course, these definitions have two distinct purposes. The first term is for external financial statement purposes. The second term is for disclosure purposes in complying with Item 13, Part III of the Form 10-K, which is often incorporated by reference from the registrant’s proxy statement. Hence, the definition pertinent to AS-18 is contained in the Financial Accounting Standards Board (FASB) Accounting Standards Codification® (ASC), which is the source of U.S. GAAP. Specifically, ASC 850-10-20 defines “related parties” to include:
This definition heavily hinges on the following terms as also defined by ASC 850-10-20: affiliate, control, immediate family, management and principal owners. Each of these terms, as well as the entire definition, requires careful understanding and attention. It is not uncommon for companies to call upon legal counsel to help ensure that the definition is appropriately applied. A misstep on this front can be a violation of U.S. GAAP. It can also potentially trigger adverse legal actions in the event an investor or creditor felt they were misled due to either a non-disclosure or an incorrect disclosure.
CHALLENGES FROM THE COMPANY’S PERSPECTIVE
The company’s objective is to have adequately designed internal controls over financial reporting that are operating effectively to reasonably ensure that errors and fraud are prevented and detected for the critical areas. This means that all relationships and transactions with related parties and executive officers, as well as significant unusual transactions, have been identified, accounted for and adequately disclosed in their financial statements.
CHALLENGES FROM THE AUDITOR’S PERSPECTIVE
The auditor’s objective is to obtain sufficient appropriate audit evidence to conclude if all significant relationships and transactions with related parties and executive officers, as well as unusual transactions, have been properly identified, accounted for and disclosed in the audited financial statements.
Obviously there are many more considerations in addressing AS-18. However, if auditors and preparers successfully answer these respective questions, they are well on their way in addressing the critical areas of AS-18.